by Archie M. Richards, Jr., CFP^®
January 17, 2005

Even if an index fund you want has had a bad record, buy it anyway.

Helen writes, "I appreciate the suggestions in your book (see archierichards.com) and in your columns about allocating with index funds to 60 percent stocks (half foreign), 20 percent real estate investment trusts (REITs), and 20 percent long-term bonds. You stopped me from chasing my tail with individual stocks.

"My portfolio is now 85 percent stocks, 5 percent REITs, and 10 percent bonds. I'd like to rebalance as you recommend, cutting back on the stocks and raising the bonds up to 20 percent. But I can't bring myself to buy more bonds, because their record has been poor. The reduced federal taxes on dividends make me favor stock funds with high dividend yields. Yet I feel I should maintain proper diversification. What's your reaction?"

I'm glad you got away from chasing individual stocks, Helen. That was smart.

Stocks are generally the best-performing sector. But inadequate diversification increases volatility and risk. Volatility on the upside is great. A vicious bear market, however, can be extremely disturbing. Most human beings react about twice as intensely to bad news as they do to equivalent good news. A decline of 30 percent in a portfolio evokes unhappiness far more intense than the pleasure we feel from a 30 percent advance.

Let's say that stock prices suffer a serious decline. As they fall, you feel more despair and shame. When the news worsens, you feel ever more fear that the prices will fall further. Finally, on an especially bad day, when most people are selling in panic, you can no longer stand it. To relieve the pain, you sell. Five minutes later, the prices start rising. You can't know it at the time, but a new bull market has begun. Having had such a miserable experience, however, you stay out until you despair about all the profits you're losing. You buy again, at much higher prices.

Not exactly the path to a fulfilling retirement.

If you're positive you won't react this way, fine, hold 100 percent stocks. But remember that most of us like to think of ourselves as normal. To resist acting as I describe is abnormal. It doesn't mean you're a sicko, but it does mean you're out of the ordinary. Diversifying among several investment sectors is the wiser course.

2004 was a disappointing year for U.S. stocks, especially the big ones. But foreign stocks did well. Did you have some of those? I hope so.

In 2004, the Vanguard REIT Index Fund climbed a spectacular 30.8 percent. Holding only 5 percent instead of 20 percent of this sector cost you a great deal of money. That's money you'll never be able to make up; it's gone.

Vanguard's Long-Term Bond Index Fund gained 8.4 percent in 2004. The record was hardly "poor," as you put it. What held you back? In your annual rebalancing, your results will worsen if you try to guess in advance which sectors will perform well and which ones won't. Individual stocks may go to zero, but index funds don't.

Remember that historic price trends predict nothing. Even if bonds had done poorly in 2004, this would have no bearing on how they'd do in 2005.

Okay, now about taxes. Let's say your portfolio is worth $100,000. You have 20 percent in bonds ($20,000). Assume this earns 5 percent interest ($1,000), which is federally taxed at 28 percent ($280).

Alternatively, you put the same amount ($20,000) into high-yielding stocks, which pay 3 percent dividends ($600), taxed at 15 percent ($90).

The taxes on the bonds: $280; and on the stocks: $90. The extra tax is $190. This is only one-fifth of 1 percent of $100,000. Buy the bonds. Proper diversification is worth the cost.

In your mid-50s, you should expect your investment time horizon to last 45 more years. Your record will be far better if you don't try to guess which sector will do well each year. Make your rebalancing automatic. Sell some of the sectors that have done well and buy more of those that haven't. Exercise judgment as little as possible. You'll be surprised how much your record will improve.